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Debt limits and sovereign default in the euro area

1.
Debt limits and sovereign default
in the euro area
Niccolò Battistini
European Central Bank
ADEMU Workshop
Fiscal Risk and Public Sector Balance Sheets
6 July 2017
The views expressed in this paper are those of the author only and do not represent those of the European Central Bank.

8.
Introduction
Questions on sustainability and welfare
What is the effect of domestically held debt on default
incentives and investor pricing decisions?
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 4 / 20

9.
Introduction
Questions on sustainability and welfare
What is the effect of domestically held debt on default
incentives and investor pricing decisions?
What is the effect of supranational ﬁscal rules on default
incentives and investor pricing decisions?
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 4 / 20

10.
Introduction
Questions on sustainability and welfare
What is the effect of domestically held debt on default
incentives and investor pricing decisions?
What is the effect of supranational ﬁscal rules on default
incentives and investor pricing decisions?
What is the assessment of debt sustainability for euro area
sovereigns?
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 4 / 20

11.
Introduction
Questions on sustainability and welfare
What is the effect of domestically held debt on default
incentives and investor pricing decisions?
What is the effect of supranational ﬁscal rules on default
incentives and investor pricing decisions?
What is the assessment of debt sustainability for euro area
sovereigns?
Do euro area sovereigns face a trade-off between welfare
and debt sustainability?
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 4 / 20

19.
The model
Main features of the model
Small open real economy with discrete time and inﬁnite horizon
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 8 / 20

20.
The model
Main features of the model
Small open real economy with discrete time and inﬁnite horizon
Agents and optimal decisions:
Households → private consumption + labour supply
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 8 / 20

21.
The model
Main features of the model
Small open real economy with discrete time and inﬁnite horizon
Agents and optimal decisions:
Households → private consumption + labour supply
Firms → labour demand
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 8 / 20

35.
The model
Domestic debt and aggregate welfare (1/2)
Two-stage interaction between government and pool of lenders:
First stage (primary markets):
Domestic and foreign lenders post their bids in auction for
government bonds.
Domestic and foreign lenders bargain over the share of total debt.
Perfect competition ensures participation in auction and
bargaining game.
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 10 / 20

36.
The model
Domestic debt and aggregate welfare (1/2)
Two-stage interaction between government and pool of lenders:
First stage (primary markets):
Domestic and foreign lenders post their bids in auction for
government bonds.
Domestic and foreign lenders bargain over the share of total debt.
Perfect competition ensures participation in auction and
bargaining game.
Second stage (secondary markets):
By the law of one price, bond prices must converge to a single
price.
Single price is the weighted average of domestic and foreign
prices.
Single price becomes the only relevant price for all agents.
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 10 / 20

37.
The model
Domestic debt and aggregate welfare (1/2)
Two-stage interaction between government and pool of lenders:
First stage (primary markets):
Domestic and foreign lenders post their bids in auction for
government bonds.
Domestic and foreign lenders bargain over the share of total debt.
Perfect competition ensures participation in auction and
bargaining game.
Second stage (secondary markets):
By the law of one price, bond prices must converge to a single
price.
Single price is the weighted average of domestic and foreign
prices.
Single price becomes the only relevant price for all agents.
Given the price, the sovereign determines the total amount of debt.
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 10 / 20

38.
The model
Domestic debt and aggregate welfare (2/2)
Notice that
default induces private losses and public returns in terms of
consumption; and
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 11 / 20

55.
Conclusions
Conclusions
Structural model-based framework with utility-based default
to assess ﬁscal sustainability.
Suitability for policy evaluation under a wide range of
economic conditions.
Inclusion of novel features (domestic debt and ﬁscal rules)
⇒ model economy appropriate for studying advanced
economies such as euro area countries.
At the current juncture, the average euro area country does
not face a trade-off between welfare and sustainability gains
⇒ ﬁscal consolidation improves both welfare and
sustainability.
Battistini (ECB) Debt limits and sovereign default in the euro area 6 July 2017 19 / 20